Rethinking the evils of current account deficits

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We live in changing times. Globalisation is changing the world's
economies and the way they work. Just this year, for instance, the
way we look at current account deficits has been turned on its
head.

When a big country runs a big deficit on the current account of
its balance of payments, some other country - or combination of
countries - must be running an offsetting surplus on their current
account.

But why do we always focus on the big deficit? Why do we always
proclaim the deficit to be "unsustainable" and likely to end in
tears? Why do we assume it's the deficit that's causing the trouble
and lecture the proprietors of that deficit about getting their
house in order?

Why are big surpluses never seen as a problem and the
proprietors of big surpluses never lectured to?

I think there are a couple of reasons for this asymmetry. One is
lingering mercantilism. Even economists fall into the unconscious
habit of seeing deficits as bad and surpluses as good.

Another reason, however, is that globalisation has changed the
way the world works without economists realising it. Their thinking
is still influenced by the fixed exchange rates that prevailed
until the 1970s and, even at this late stage, hasn't fully adjusted
to a world of floating exchange rates and highly integrated
financial markets.

In the world of the Bretton Woods agreement, where capital flows
between countries were tightly controlled, it was current account
deficits the monetary authorities worried about.

Would there be enough capital inflow to finance the deficit, or
would there be a rundown in the country's reserves of foreign
exchange? If reserves ran down too much, the country would face a
"balance of payments crisis" leading to a humiliating devaluation
of its currency - an event seen as sure proof of mismanagement.

So, rather than go through all that, governments that saw their
current account deficits blowing out would try to get them back
down in a hurry by using higher interest rates and tough budget
measures to crunch their economies.

By contrast, governments with growing current account surpluses
had little cause to worry. The disposal of the surplus could be
left to the private sector.

Another part of this thinking was that, because capital flows
were so constrained, the action was always in the trade and current
accounts, never the capital account. So we got into the habit of
assuming the current account drove the capital account, never the
other way round.

One of the big changes since those days, of course, is the
remarkably free and rapid flows of "hot money" - bank loans and
portfolio investment, as opposed to foreign direct investment -
between countries.

This development may well have reversed the "direction of
causation", so that the capital account now drives the current
account.

But let's get down to cases. The United States has been running
ever-larger current account deficits, particularly in recent years.
The latest blowout has been accompanied by a dramatic turnaround in
the US budget balance as the US dropped into a mild recession and
the Bush Administration followed up with spending increases and
huge tax cuts.

At the same time, US household saving has been weak as America
has experienced a real estate boom similar to ours.

Many people (myself included) have been terribly worried by all
this "imbalance", arguing that it's unsustainable and could easily
end in disaster.

The point must surely come when foreign investors become
unwilling to continue financing this profligacy. And when that
point is reached, a sudden loss of confidence could precipitate a
collapse in the US dollar.

This would begin the process of getting the current account
deficit back down, but could well involve much disruption to the US
economy, including possibly a sharp rise in interest rates and even
a drop back into recession.

According to this conventional wisdom, the Americans must try to
head off disaster by moving immediately to get their house in
order. And the obvious place to start is to get their budget
deficit back under control.

Heard all that before? I bet you have. But this year, a then
governor of the US Federal Reserve, Ben Bernanke, gave a couple of
speeches in which he turned the conventional wisdom on its
head.

And our own central bank governor, Ian Macfarlane, gave a speech
recently (republished this week in the Reserve's monthly
Bulletin) in which he endorsed and elaborated on the new
line.

The new argument says the root cause of all the global imbalance
is not America's big current account deficit, but Asia's big
surpluses.

Last year, Japan ran a current account surplus of 3.7 per cent
of its gross domestic product; China ran one of 4.2 per cent and
other East Asian economies a combined surplus of 6.3 per cent.

Whether it's a surplus or a deficit, the balance on the current
account is equivalent to the difference between how much a nation
saves and how much it invests at home.

So the problem is the Asians have been saving more than they
want to invest, leaving a surplus that has to be invested somewhere
else in the world. Had the Americans not been willing to take those
capital inflows - and use them to make up for their dearth of
saving relative to investment - the world economy would have been
much weaker than it was. Indeed, it would have been in
recession.

So that's the "glut of savings" argument. Now, you may object
that it's a terribly convenient argument for the free-spending
Yanks to be running.

That's obviously true. But, as Mr Macfarlane has argued, it
actually fits all the facts better than the story that blames the
global imbalance on the US. In particular, it explains why US and
world long-term interest rates are so low at present.

If the Americans are having to attract from a reluctant world
all the funds needed to finance their big deficits, how come their
currency is still quite strong and their long-term interest rates
so low?

If the quantity of loanable funds demanded has been rising, how
can the price of those funds (long-term interest rates) have been
falling? The obvious answer is that the supply curve must have
shifted out to the right.

That is, there must have been an increase in the global supply
of loanable funds. And there was. For their own reasons, the Asians
decided to cut their investment relative to their (amazingly
strong) saving.

So, contrary to conventional thinking, the source of the global
imbalance is Asia, not America.